Target Date Versus Relative Risk: A Comparison of 2 Retirement Strategies

Transcription

1 Versus Relative Risk: A Comparison of 2 Retirement Strategies MARCH 2014 CONTRIBUTOR Peter Tsui Director, Index Research & Design peter.tsui@spdji.com Target date funds have grown significantly over the past decade. In fact, assets attached to all U.S. target date indices exceeded USD 500 billion in the first quarter of The underlying premise of target date strategy is a varying derisking glide path, shifting from a high equity risk level to a low equity risk level over time. This generally has an intuitive appeal, as people may be concerned that their portfolios would not recover if the market were to experience a significant drop shortly before their retirement. However, by the same token, they may worry that they could miss out on positive markets by being too conservative. In this study, we seek to determine how target date strategy performs when compared with a suite of relative risk strategies. Which of the Strategies Would Perform Best in Different Markets? Using historical data from 1983 to 2013, we conducted 12 case simulations, labeled A through L. In each case, five relative risk strategies and one target date strategy were modeled over a 20-year period. We created six hypothetical portfolios for each participant in each case, and personified the portfolios associated with the strategies by inventing names for hypothetical participants (Alice through Larry). The Demographic Profile The 12 hypothetical cohorts have birth years ranging from 1938 to We postulate that each of the cohorts begin saving for their retirements at age 45. As such, Alice and her generation (all born in 1938) would start their savings regimen at the beginning of January The appropriate underlying target date strategy would be the one with target date maturity in 2005, as this is designed for participants anticipating retirement between 2001 and RESEARCH 1 See

2 Exhibit 1: The 12 Cohorts Case Name Year of Birth Age Started Saving Saving Since Underlying TD Strategy A Alice B Brian C Craig D David E Edward F Francine G George H Hank I Irene J Justin K Kathy L Larry The five relative risk strategies are labeled RR100, RR80, RR60, RR40 and RR20, where the numerical values indicate the level of equity risk for the relative risk portfolios. For the target date strategies, we assigned the participants the appropriate target date indices in accordance with the year of their retirement. Hypothetical participants Alice, Brian, Craig and David were assigned the Dow Jones 2005 index. Edward, Francine, George, Hank and Irene were assigned the Dow Jones 2010 index. Justin, Kathy and Larry were assigned the Dow Jones 2015 index. Each participant s portfolio is constructed as follows. At the beginning of the 20-year period, beginning at the age of 45, the participant would start to contribute USD 1,000 to an investment account on a monthly basis, at the beginning of each month, for 20 years (or 240 months). At the end of the 20-year period, the total contributions would be USD 240,000, and the ending values would be determined based on the monthly returns of each of the 240 months. For example, our first participant, Alice, would begin putting in the USD 1,000 at the end of December Her final contribution would be at the end of November As seen in Exhibit 2, her portfolio would have grown to USD 705,291 if she had invested with the Dow Jones 2005 index, or to USD 526,410 if she had invested with the RR100 index. The USD 705,291 value at the end of the 20-year period ( ) is equivalent to an internal rate of return (IRR) of 9.43%. For the relative risk indices, we used the Dow Jones Global Relative Risk Indices. For the target date indices, we used the Dow Jones Global Indices. Both of these index series use the same underlying building blocks, thus allowing us to test the difference in impact between varying and non-varying asset allocations. For a detailed presentation of the composition and methodology of the Dow Jones Global Relative Risk Indices and the Dow Jones Global Indices, please refer to the Dow Jones Relative Risk Indices Methodology and the Dow Jones Indices Methodology. 2

3 Exhibit 2: Simulation Results 20-Year Ending Balance in USD RR100 RR80 RR60 RR40 RR20 Strategy A Alice 526, , , , , , B Brian 679, , , , , , C Craig 723, , , , , , D David 736, , , , , , E Edward 792, , , , , , F Francine 785, , , , , , G George 422, , , , , , H Hank 538, , , , , , I Irene 582, , , , , , J Justin 500, , , , , , K Kathy 531, , , , , , L Larry 616, , , , , ,817 Maximum 792, , , , , ,623 Average 619, , , , , ,178 Minimum 422, , , , , ,817 Spread 369, , , , , ,806 Source: S&P Dow Jones Indices. Monthly returns from Dow Jones Series and Dow Jones Relative Risk Series, All returns are hypothetical. Charts and graphs are provided for illustrative purposes. Past performance is no guarantee of future results. The pattern embedded in the simulation results can be seen more clearly when the results are normalized. To see the relationship among the five relative risk strategies, we normalize the results using the RR100 ending values as the anchor. Exhibit 3: Normalized 20-Year Ending Balance Results Using the RR100 Strategy as the Anchor RR100 RR80 RR60 RR40 RR20 Strategy A Alice B Brian C Craig D David E Edward F Francine G George H Hank I Irene J Justin K Kathy L Larry Source: S&P Dow Jones Indices. Monthly returns from Dow Jones Series and Dow Jones Relative Risk Series, Note: Highlighted areas indicate results above All returns are hypothetical. Charts and graphs are provided for illustrative purposes. Past performance is no guarantee of future results. With the exception of cases A and G, the five relative risk strategies exhibited a pattern that is expected; the ending values were higher for higher relative risks. For case G, the poor market in 2008 was a key factor. In Exhibit 3, we also see that the target date strategy outperformed the relative risk strategies in three of the 12 cases, and it was a draw in a fourth case (for Justin). When we switch the normalizing anchor from RR100 to the target date strategy, we see another interesting pattern emerge (see Exhibit 4). 3

4 Exhibit 4: Normalized 20-Year Ending Balance Results Using the Strategy as the Anchor RR100 RR80 RR60 RR40 RR20 Strategy A Alice B Brian C Craig D David E Edward F Francine G George H Hank I Irene J Justin K Kathy L Larry Source: S&P Dow Jones Indices. Monthly returns from Dow Jones Series and Dow Jones Relative Risk Series, Note: Highlighted areas indicate results above All returns are hypothetical. Charts and graphs are provided for illustrative purposes. Past performance is no guarantee of future results. The target date strategy portfolios almost always outperformed the RR40 and RR20 portfolios, but they were inferior to RR100 in eight out of 12 cases. Since none of the participants can predict future earnings or performance, they may be satisfied with a target date strategy that performed relatively well, even if it was not optimal. We also calculated the IRRs for these portfolios (see Exhibit 5). Exhibit 5: Annualized IRR RR100 (%) RR80 (%) RR60 (%) RR40 (%) RR20 (%) Strategy (%) A Alice B Brian C Craig D David E Edward F Francine G George H Hank I Irene J Justin K Kathy L Larry Maximum Minimum Spread Average Median Mean Absolute Deviation Sample Std. Dev Source: S&P Dow Jones Indices. Monthly returns from Dow Jones Series and Dow Jones Relative Risk Series, All returns are hypothetical. Charts and graphs are provided for illustrative purposes. Past performance is no guarantee of future results 4

5 Exhibit 6 shows the overperformance or underperformance of the relative risk portfolios with respect to their target date strategy counterparts. Exhibit 6: Relative Annualized IRR (Relative Risk-) RR100-TD RR80-TD RR60-TD RR40-TD RR20-TD A Alice B Brian C Craig D David E Edward F Francine G George H Hank I Irene J Justin K Kathy L Larry Max Min Average Median Source: S&P Dow Jones Indices. Monthly returns from Dow Jones Series and Dow Jones Relative Risk Series, All returns are hypothetical. Charts and graphs are provided for illustrative purposes. Past performance is no guarantee of future results. Observations First, on average, taking more risk would have paid off in these situations. The RR100 (100% equity risk portfolio) has an average IRR of 8.23% vs. 7.85% for the target date strategy portfolio over the most recent 30 years market conditions. However, results vary on an individual participant basis. For example, in George s cohort, the 20-year IRR for the RR100 was only 5.23% because of the financial meltdown in Most prospective retirees are afraid of precisely this situation: what if the year before they are about to retire, when their savings would be at their highest, the market turns against them? If George had been following a target date strategy, the IRR would have been 6.67%. This result is still significantly less than the average IRR of 7.85%, but not devastatingly so. Second, even though the target date strategy did not have a fixed equity allocation by design, it came closest to the RR80 strategy in terms of its overall performance over these empirical comparisons. The mean absolute deviation for these strategies is identical at 1.14, and the average returns are 7.93% for the RR80 vs. 7.85% for the target date strategy. However, the target date strategy may seem to be the better choice, as it has a smaller spread between its best and worst returns (3.34% TD vs. 4.12% RR80), smaller sample standard deviations (1.25 TD vs RR80), and a higher minimum historical return (6.35% TD vs. 5.48% RR80). The average difference in the IRRs was 0.08% (see Exhibit 6). Third, over the past 30 years, the bond markets enjoyed a secular boom, as the long-term Treasury rates moved from a high of 15% to a low of 2%. Thus, cohorts whose retirement horizons were in the first decade of the 21 st century (like Alice and Brian) benefited from a healthy return derived from the fixed income component of their portfolios. As a result, Alice and Brian were the only cohorts whose target date strategy portfolios beat the relative risk portfolios in rising markets. The same cannot be said for Larry, as the fixed income portion of his portfolios had a negative return in 2013 and his target date strategy portfolio suffered accordingly, despite a booming stock market. 5

6 Finally, the specific ending wealth of the 12 cohorts clearly depends on the paths the markets took over their investment periods. Adopting the target date strategy may not deliver the best results most of the time, but it seems to avoid the worst outcomes more reliably. ABOUT S&P DOW JONES INDICES S&P Dow Jones Indices LLC, a part of McGraw Hill Financial, Inc., is the world s largest, global resource for index-based concepts, data and research. Home to iconic financial market indicators, such as the S&P 500 and the Dow Jones Industrial Average TM, S&P Dow Jones Indices LLC has over 115 years of experience constructing innovative and transparent solutions that fulfill the needs of institutional and retail investors. More assets are invested in products based upon our indices than any other provider in the world. With over 830,000 indices covering a wide range of assets classes across the globe, S&P Dow Jones Indices LLC defines the way investors measure and trade the markets. To learn more about our company, please visit Like What You Read? Sign up to receive complimentary updates on a broad range of index-related topics and events brought to you by S&P Dow Jones Indices. 6

7 GENERAL DISCLAIMER S&P Dow Jones Indices LLC, a part of McGraw Hill Financial All rights reserved. Standard & Poor s and S&P and S&P 500 are registered trademarks of Standard & Poor s Financial Services LLC ( S&P ), a part of McGraw-Hill Financial, Inc. Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC ( Dow Jones ). Trademarks have been licensed to S&P Dow Jones Indices LLC. Redistribution, reproduction and/or photocopying in whole or in part are prohibited without written permission. This document does not constitute an offer of services in jurisdictions where S&P Dow Jones Indices LLC, Dow Jones, S&P or their respective affiliates (collectively S&P Dow Jones Indices ) do not have the necessary licenses. All information provided by S&P Dow Jones Indices is impersonal and not tailored to the needs of any person, entity or group of persons. S&P Dow Jones Indices receives compensation in connection with licensing its indices to third parties. Past performance of an index is not a guarantee of future results.it is not possible to invest directly in an index. Exposure to an asset class represented by an index is available through investable instruments based on that index. S&P Dow Jones Indices does not sponsor, endorse, sell, promote or manage any investment fund or other investment vehicle that is offered by third parties and that seeks to provide an investment return based on the performance of any index. S&P Dow Jones Indices makes no assurance that investment products based on the index will accurately track index performance or provide positive investment returns. S&P Dow Jones Indices LLC is not an investment advisor, and S&P Dow Jones Indices makes no representation regarding the advisability of investing in any such investment fund or other investment vehicle. A decision to invest in any such investment fund or other investment vehicle should not be made in reliance on any of the statements set forth in this document. Prospective investors are advised to make an investment in any such fund or other vehicle only after carefully considering the risks associated with investing in such funds, as detailed in an offering memorandum or similar document that is prepared by or on behalf of the issuer of the investment fund or other vehicle. Inclusion of a security within an index is not a recommendation by S&P Dow Jones Indices to buy, sell, or hold such security, nor is it considered to be investment advice. Closing prices for S&P US benchmark indices and Dow Jones US benchmark indices are calculated by S&P Dow Jones Indices based on the closing price of the individual constituents of the index as set by their primary exchange. Closing prices are received by S&P Dow Jones Indices from one of its third party vendors and verified by comparing them with prices from an alternative vendor. The vendors receive the closing price from the primary exchanges. Real-time intraday prices are calculated similarly without a second verification.] These materials have been prepared solely for informational purposes based upon information generally available to the public from sources believed to be reliable. No content contained in these materials (including index data, ratings, credit-related analyses and data, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse-engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of S&P Dow Jones Indices. The Content shall not be used for any unlawful or unauthorized purposes. S&P Dow Jones Indices and its third-party data providers and licensors (collectively S&P Dow Jones Indices Parties ) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Dow Jones Indices Parties are not responsible for any errors or omissions, regardless of the cause, for the results obtained from the use of the Content. THE CONTENT IS PROVIDED ON AN AS IS BASIS. S&P DOW JONES INDICES PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT S FUNCTIONING WILL BE UNINTERRUPTED OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Dow Jones Indices Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs) in connection with any use of the Content even if advised of the possibility of such damages. S&P Dow Jones Indices keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P Dow Jones Indices may have information that is not available to other business units. S&P Dow Jones Indices has established policies and procedures to maintain the confidentiality of certain non-public information received in connection with each analytical process. In addition, S&P Dow Jones Indices provides a wide range of services to, or relating to, many organizations, including issuers of securities, investment advisers, broker-dealers, investment banks, other financial institutions and financial intermediaries, and accordingly may receive fees or other economic benefits from those organizations, including organizations whose securities or services they may recommend, rate, include in model portfolios, evaluate or otherwise address. 7